Mosaic Software has an opportunity to invest $10,000,000 in a new engineering remote-control system for offshore drilling platforms in partnership with two other companies. Financing for Mosaic will be split between common stock sales ($5,000,000) and a loan with an 8% per year interest rate. Mosaic’s share of the annual net cash flow is estimated to be $1,115,000 for each of the next 6 years. Mosaic is about to initiate CAPM as its common stock evaluation model. Recent analysis shows that it has a volatility rating of 1.05 and is paying a premium of 5% common stock dividend. Risk-free government bond investments are currently paying 4% per year. Is the venture financially attractive if the MARR equals (a) the cost of equity capital, and (b) the WACC? (Note: Refer to problem
10.52 for further analysis of this investment opportunity.)
What will be an ideal response?
(a) Find cost of equity capital using CAPM.
Re = 4% + 1.05(5%)
= 9.25%
MARR = 9.25%
Find i* on 50% equity investment.
0 = -5,000,000 + 1,115,000(P/A,i*,6)
i* = 9.01% (RATE function)
The investment is not economically acceptable since i* < MARR.
(b) Determine WACC and set MARR = WACC. For 50% debt financing at 8%,
WACC = MARR = 0.5(8%) + 0.5(9.25%)
= 8.625%
The investment is acceptable, since 9.01% > 8.625%.
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